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Monday, November 30, 2009

New sources of financing for microfinance assets

by Nachiket Mor.

The problem

The main source of funding for microfinance in India has been through banks, primarily through the forced `priority sector lending'. Over the years, the demand for funds in the microfinance industry has outpaced the growth in investment by banks. In addition, banks are not the ideal place for these assets, given the nature of cashflows and maturity of micro loans. Hence, even though MFI assets are part of priority sector lending, the excessive focus on bank capital has effectively raised the cost of capital for MFIs.

The upstream funding for microfinance needs to be diversified to harness a diverse array of borrowers, so as to avoid the constraints and unique compulsions of any one source. However, at present in India, MFIs are not permitted to mobilise deposits, or borrow from international lenders, or from MIVs (Microfinance Investment Vehicles).

The role for securitisation

The ideal financing channel for them, in this environment, is securitisation. Through securitisation, a pool of loans across many borrowers (and ideally across many MFIs) would be turned into a tradeable securities that are targets of investment by a diverse array of investors, with different beliefs and compulsions.

A recent transaction

One step towards this goal came about last week, when IFMR Capital announced the completion of a micro-loan securitisation through which mutual fund investment into microfinance takes place. The Rs.480 million ($10.4 million) transaction is backed by over 55,000 micro-loans originated by Equitas Micro Finance, a Chennai-based microfinance institution (MFI) with approximately 700,000 low-income clients.

The bulk of the securities issued were purchased by ICICI Prudential AMC, the country's third largest mutual fund. The entry of a mutual fund investor into the micro-loan backed securities (MLBS) market, as well as the treasury desks of major Indian banks, has given Equitas a new investor base and lower cost of financing. This should enable lower cost borrowing for the households that Equitas lends to.

Deeper implications

Going beyond the direct issue of access to a large volume of funds at a low cost, capital market financing is beneficial to microfinance firms by bringing about new pressures on transparency, accountability and thus oversight of MFIs.

IFMR Capital has previously done a MLBS transaction, but there it was the sole investor in the BBB rated (subordinated) tranche. In the Equitas transaction, there was investor interest in all tranches; a majority of the BBB tranche was purchased by a private bank. This is relatively new for the Indian corporate bond market, which has hitherto been wary of BBB securities. These developments are thus synergistic for both the growth and development of microfinance and for the corporate bond market.

The ultimate goal is an ecosystem where securitisation paper is constructed using loans made by multiple MFIs, sold to a diverse array of domestic and foreign investors, actively traded on the secondary market, with trading that is supported by high quality disclosure of data about the underlying loans on a daily basis. IFMR Capital will work in all aspects of this ecosystem, including facilitating listing and engaging in market making.

Looking beyond the vision of MFIs funding themselves through securitisation, there is also a role for (say) 1000 small banks (as argued in Raghuram Rajan's report). A key ingredient of making this work is bringing in market discipline, by having regulations which require them to finance (say) a quarter of their assets using subordinated debt, and using this BBB bond market to exercise market discipline on them. The task of bank supervisors would be simplified when the BBB bond market, the CDS market and the stock market jointly serve up a list of the 50 weakest banks on each trading day. The stock market is in place in India; what is now missing is the BBB bond market and the CDS market.

securitization of microfinance asset pools.. phew.. i wonder whether this would go the MBS/ ABS way.. though the bust of MBS/ ABS happened because of asset bubble, but i wonder the lending practices of MFI's are how strict.. plus though there are very large number of people involved with each having small due of loan.. but they might be linked to agricultural/ tertiary economy and any bad monsoon/ famine/ any natural calamity could dent their payment capacity and more so of a particular region.. plus with so many MFI's ready to dole out money, if people start availing multiple loans then this would further lead to debt trap.. and the day i hear that Crisil/ ICRA/ Fitch have started rating these pools as AAA or something, i will know that a big bust will be in the making..

It is very encouraging to read your article on securitisation of MFI loans and your wishes to take it to a more commercial level where foreign investors can participate. I am not sure if that requires new regulation to be place as this will delay the process. In Bangladesh, BRAC NGO had done securitisation of the loan portfolio in 2006 and had also attracted many foreign institutional investors. Though the capital market in Bangladesh is not mature enough still involvement by foreign investors in the deal was commendable. That deal can be a good example for Indian financial institutions as how to attract foreign investors. Also lately a microfinance institute has created a CDO structure along with Deutsche Bank (Microfinance group in CDO scheme, an article in Financial Times), which shows the appetite of institutional investors in Microfinance. I would like to end this with a positive note .. that it is just the beginning.

Thank you all for your comments. There is no question that any such effort needs to be handled with a great deal of care and attention. We also however need to remember that while there are clearly lessons for us in India from the financial markets crisis in USA our markets are at a very different stage of development and our experiences with securitisations have thus far been quite positive.

We also need to be careful about what are the implicit alternatives we have in mind if we are concerned with these developments -- limited financial access, deposit taking by under-capitalised financial institutions to finance their assets, large institutions seeking to do direct origination using credit scoring without ever meeting the customer, much wider coverage of deposit insurance amounting to transfer of all risks to the tax-payer.

The securitization of MF loans is a very noble concept. But I wonder, that RBI has indicated in its credit policy that to securitize any loan portfolio it must be in the books of originator for atleast 1 year. As we know that maximum loans in Microfinance industry are of 1 year duration, how feasible is this securitization route ? Or is the directive not applicable for Microfinance sector ?

@AJ - I guess these Microfinance loans are backed by heavy FLDG and SLDGs. Its only after these Guarantees Rating agencies are comfortable in rating them at Investment Grade. The risks do exist but historically the repayment rate in the Microfinance sector has been very good. These kind of instruments would bring in more transparency into the system and obviously with multi originator loans the risk of heavy impact becuase of some natural disaster would also get minimized. But, there is hardly any proven model to predict the probability of default of microfinance loans underlying, hence they are prone to error and with issues such as in Kolar coming up its difficult to build a robust model. I am optimistic that with time better models would come into place and as the debt market in India matures, a robust securitization practices would be established and market for these products would also get widened

I feel that it is perhaps more a monetary policy measure aimed at slowing credit growth from the banking system rather than a credit risk containment measure -- at the moment there is no evidence that the credit rating agencies are under-estimating the credit risk of these instruments.

@ Hemant and Nachiket- The minimum holding requirement is a proposal at this stage and RBI may come out with detailed guidelines later.

Below is the relevant extract from the Second Quarter Review ofMonetary Policy 2009 -10.

Lock-in Period and Minimum Retentionfor Securitisation Exposures

161. To ensure that the originators do not compromise on due diligence of assets generated for the purpose of securitisation, it was proposed in the Annual Policy Statement of April 2009 to stipulate a minimum lock-in period for bank loans before these were securitised. It was also proposed to lay down minimum retentioncriteria for the originators as another measure to achieve the same objective.

Accordingly, it is proposed:

• that the minimum lock-in period for all types of loans would be one year before these can be securitised; and

• that the minimum retention by theoriginators will be 10 per cent of the pool of assets being securitised.

162. The international work, especially in the European Union and the US regarding the minimum retention criteria, is still underway. The Reserve Bank willissue detailed guidelines on the manner of computation of the one year lock-in period and other operational details keeping inview the international norms beingdeveloped.

Post the credit crisis, both investors as well as rating agencies recognise that the incentive of the originator to maintain due diligence, collection and servicing standards is critical to the credit quality of the portfolio.

Equitas, the originator holds a first loss piece equal to 11.4% of the principal amount of the securities issued by the spv. This is akin to capital for the MFI originator, as first loss pieces retained have to be deducted from tier 1 and tier 2 capital of the originator(as per RBI guidelines). Also, IFMR Capital (who does the due diligence on the originator as per its underwriting guidelines), also holds a portion of the BBB rated second loss security.

I think it is important that both the originator as well as the financial intermediary have a stake to ensure effective selection, supervision and control of the originator, and proper due diligence and monitoring by the originator of the underlying loans.

These are features that were absent in most sub prime securitisations closed in the US in the last 4-5 years.

Anurag Gupta (www.carnegie-rochester.rochester.edu/nov08-pdfs/berndt_gupta.pdf) in his analysis of loan originators in the US, recommends that "One solution could be to impose restrictions on the sale of the loans that the banks originate, in terms of requiring them to hold at least a certain percentage of thoseloans on their books. This would hinder banks from originating bad loans, and would preserve some of the beneﬁts of bank monitoring of borrowers. There should of course be additional disclosure requirements on all participants in the loan sales market, in orderto reduce the occurrence of adverse selection. Lastly, the establishment of a loan tradingexchange with a clearinghouse could beneﬁt all market participants by way of greatertransparency and regulatory oversight."

We must learn from these lessons to build out new sources of financing for the microfinance sector within a stable financial system.

In substance there is much merit in what you are saying; these arrangements that have been setup do indeed address the problem that was seen in the US in the last 5-10 years. But:

(a) The credit rating piece remains shaky. We have to find ways to get the relationship between the originator and the bond market to function without credit rating agencies as we know them today, and

(b) The subordinated pieces which are held by the originator in order to align incentives could prove to be futile if the originator resorts to OTC derivative positions to layoff this risk. Closing this loophole is, sadly, not easy. (At the simplest - could IFMR Trust sell off the subordinated stuff tomorrow?)

I think you are right in saying that your incentive environment is much better than what was present in the US, but more work is needed to hammer down the weak links.

I think securitisation is a fantastic technology, but we need to fully re-engineer the building blocks of information and incentives to make it work properly.

I agree with you although a rating is necessary, it is not sufficient. We cannot rely on the rating piece, by the same argument of incentives. The reputations of all the international rating agencies have been damaged by the crisis, the underlying rating methodologies are being questioned given the performance of the assets and the fragility of ratings(however, to be fair, crisil has had a great record in structured finance during the same period)

I think the originator's own incentives and the financial intermediary's own incentives are much more powerful ways to ensure maintenance of quality of origination.

Today, as the corporate bond markets are very illiquid, and the BBB spectrum in particular even more so, there is much incentive for IFMR Capital to do its job well, as it has invested as "principal". As a matter of choice, IFMR Capital will always retain a significant proportion of the second loss security.

However, it is important to understand how the system will stack up, once there is a liquid BBB market, and the prospects of an easy sell are more real. Perhaps market making in the securitised notes could be another way of ensuring that capital is committed as well as promote deeper liquidity.

The success of securitization lies in the quality of underlying assets and the incentive structures. Therefore, the world over, high quality MFIs can become perfect clients for securitizations, because of their extremely low default rates. Industry average of default rate of Indian MFIs is less than 2% which is lesser than any other similar loan product like credit card, auto loans etc.

In India, the microfinance market has been resilient in times of recession. As per the “state of the sector report”, MFIs have grown by 29.8% in number of districts in they operate whereas, number of clients added is increased by 60% in last year. However, there is still a large untapped market and better funding channels can further amplify their growth.

Securitization can act as a flexible funding channel for MFIs by connecting them to financial markets. It can help MFIs in getting the market based valuation of their assets, which lowers their cost of capital and increase funding channels. However, information requirements in the capital markets are very intensive and to deal with that MFIs have to improve their processes and systems which include their MIS, cash management etc. This may require some investment initially, but in the long run these improvements will reap great benefit.

I feel that, to realize the benefits of securitization, the small size of majority of Indian MFIs comes as a big entry barrier.

One solution to this problem can be to organize a multioriginator securitization. Through a multioriginator structure, loans from different MFIs can be pooled together to create a viable transaction size. This structure can reduce the costs to small MFIs as MFIs can share costs of credit rating, legal opinion and cost of structuring etc. To appeal to investors, multioriginator transaction diversifies the portfolio across various geographies and servicers.

India has not seen a multioriginator securitization yet, hopefully we will see one soon.

They underlying belief is that only small and local institutions can really deliver finance as a welfare enhancing service (as different from the finance as a product in which service is outsourced). The key issue is how do they get competitively financed -- on the debt front it looks like MOSECs and perhaps CDOs are a far better choices for them than allowing them to accept deposits on their own balance sheet. On the savings front they should ideally act only as conduits to Mutual Funds or larger, well capitalised banks, at least initially.

At a later date once they have acquired some critical mass and have shown themselves to be "fit and proper" they could perhaps collect deposits on their balance sheet and manage their idiosyncratic risk exposure by, among other things, purchasing MOSECs or Credit Derivatives or buying Parametric Insurance Products.

All these credit intermediation can be done by real resources producing agencies.All these stock market and commodity market instruments cannot be miniatiarised with benefit.further collapse of business activity and failures are dime a dozen in MFI market.Many small chettiar type financing with jargon of microcredit are trying to fleece the poor.they say No-profit but squeeze the poor with high rates and cheat them with many comapnies in one name.If you see the mfi comanies they may be trusts they may be corporate bodies and many are partnerships...all cheat the poor concertedly.RBI and other agencies don't have enough experience in this regard.Banks were not forced to release priority sector lendings.they were forced for political reasons with the view to make losses for them with future and elusive social benefit.after all currency is simply printed with imaginary parameters which even the Govt cannot hold on with confidence.This MFI activities are adding burdens to society and waste the time of poor people and they spent their time toiling for these usuriuos goons.

The role of micro finance in poverty alleviation and empowerment has been well recognized. Clients, specially women, for whom traditionally the local moneylenders was the only alternative sources of credit, are getting credit at much lower interest rates from a more formal institution - the micro finance institution. The sector has witnessed huge growth in the last decade and the activities of MFIs are no longer confined to extending credit. These institutions have come up with innovative insurance and saving product to expand the gamut of financial service provided to the poor. The understanding of the MFIs is much more than any other financial institution serving this segment of the society. The process of group formation, assessment of the borrower by the loan officer, the weekly collection model along with the joint liability by the group has been responsible for the high repayment rate in the microfinance sector. Entry of professionals with finance and banking experience has brought in the rigor of lending business while the promoters with social focus have ensured alignment to the mission. This synergy has helped in improving the service quality, brought in innovative products which have resulted in high growth rate. Investment in systems and technology has enabled the MFIs to generate accurate reports and manage large number of clients. There has been much discussion about the high interest rates charged by MFIs. I firmly believe that interest rates should be market determined. Implementation of fair practice code by RBI has ensured disclosure of rates including fees. Educating the client about the effective interest rate being charged has resulted in MFIs being more transparent. With economies of scale and scope kicking in the sector, there has been a decrease in interest rate as well as transaction costs. To achieve scale and be sustainable most of the MFIs have either transformed themselves into an NBFC or are in the process of doing so. These NBFCs are subject to the direct supervision of RBI as non banking financial companies (NBFCs). To state that the RBI does not have the experience to deal with them is incorrect.The funding to MFIs has largely been because of priority sector lending requirements. To make sure that the banks understand the risks involved when they lend to MFIs, most of them have a detailed due diligence process to understand the functioning of micro finance institutions or depend on rating agencies who have developed their own tool for grading/rating microfinance institutions. Large numbers of localized rural financial institutions are coming up with innovative models to deliver multiple products to the unbanked sector. To conclude that MFIs are adding burden on the society will be a gross misjudgement on our part on the important role that MFIs are playing in financial inclusion.

IFMR Capital just closed a Rs. 30 cr microfinance securitisation of a pool of JLG loans originated by Asirvad Microfinance Pvt Ltd, Sahayata Microfinance Pvt Ltd, Satin Creditcare Network Ltd, and Sonata Finance Pvt Ltd. To the best of their understanding, this is the first multioriginator securitization of micro-loans in the world and of course the first of its kind in India. This deal is significant for several reasons:

-The senior-most tranche was rated P1+ by Crisil -This is the first multioriginator securitisation in microfinance that pools loans from four small, fairly new MFIs-The transaction has resulted in the emergence of a new pricing benchmark in the less than 6-month maturity asset class-This will provide significant reduction in overall cost of funding to the MFIs

They expect this to change the way microfinance institutions access debt funding at much cheaper rates and much more efficiently, reliably and quickly. This will also aid in creating a level playing field for MFIs, irrespective of size and vintage, where the only variable that will determine access to capital markets will be the underlying quality of the MFI and its assets. By pooling together loans portfolios of these small yet high quality MFIs, we have demonstrated that securitisation can be a viable option even for the smaller players in this sector. IFMR Capital is an investor in the subordinated strip of the securitisation.

The P1+ rated senior tranche in the above mentioned multi originator securitisation was purchased by the treasury department of a bank. This demonstrates that microfinance can form a mainstream asset class, benchmarked to comparably rated assets like P1+ rated commercial paper, and not just be relegated to the priority sector portfolio of banks.

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